Barron’s in August of this year published an article critical of SolarCity’s use of tax credits and grants for its solar projects.1 That article led Senator Sessions to send a harsh letter with a number of pointed questions to the Secretary of the Treasury. My blog post regarding the senator’s letter is available here. SolarCity has now posted a response to the Barron’s article on its own blog. SolarCity’s post is available here.

Overall SolarCity’s post is thoughtful and clear. However, the post’s wording contains a technical misstatement with respect to federal income tax law:

“SolarCity does not use a ‘more complex’ method than similar installers in valuing solar projects, and solar companies cannot “estimate” the fair market value in applying for grants under Section 1603. That fair market value-which of course is the price the buyer actually paid for the system-must also be determined by an independent appraiser.”

The author of the post may not be aware that one of SolarCity's, as well as other solar developers, preferred structuring techniques is the inverted lease.2 In an inverted lease, the 1603 grant or investment tax credit is based on the fair market value of the solar project, which is not what the party claiming the tax credit or grant has paid.

The use of the fair market value that was not paid by any party in a lease transaction was sanctioned by Congress in section 50(d)(5) of the Internal Revenue Code, which cross-references to old section 48(d), which was repealed by Congress but effectively reinstated by the cross-reference. Old section 48(d) provided: “A person . . . who is a lessor of property may elect with respect to any new [investment tax credit eligible] property to treat the lessee as having acquired such property for an amount equal to . . . the fair market value of such property” (emphasis added).

Pursuant to this election, a lessor may elect to permit the lessee of a solar project to claim the grant or investment tax credit, even though the lessee is not the owner of the project. As the lessee is paying rent (rather than buying the project), the lessee’s grant or investment tax credit is based on the notional fair market value of the project.

For instance, if the solar project’s fair market value is $100,000, under this election the lessee is eligible for a $30,000 grant or investment tax credit the investment tax credit in the first year the project is operational, while the lessee to that point likely has paid rent nowhere near $100,000. Further, the lessor may be a developer that constructed the project itself at a cost of only $85,000. Therefore, the $100,000 fair market value the grant or investment tax credit is based on does not correlate to what either party has “paid for the system.”

Thus, SolarCity does in some instances use a complex method that results in an investment tax credit or cash grant based on the estimated fair market value of the project. Therefore, contrary to SolarCity’s blog post, the “fair market value” in this scenario that is a preferred structure of SolarCity3 is not “of course . . . the price the buyer actually paid for the system” as quoted.

SolarCity’s blog post also over-emphasized the specificity of the appraisal guidelines provided by the IRS: “The IRS provides guidelines for appraisal methods for establishing the fair market value of assets. . . . The entire energy industry uses the same methodology that is stipulated by the IRS.”

I wish the IRS had “stipulated” a “methodology” for valuing solar project, unfortunately, in my experience the IRS’s valuation guidance is far more opaque than any stipulation I have read. The applicable tax regulations defining fair market value merely refer to the price determined in an arm’s-length transaction between a willing buyer and willing seller.4 Such generalities are hardly a “methodology.” The IRS manual and case law provide some detail with respect to the three typical methods of valuation: (i) discounted cash flow; (ii) comparable transactions in the market; and (iii) replacement cost.5 However, even those sources do not provide much specificity with respect to how to reconcile the different results each of the three methods may produce.

The Treasury did publish a memorandum on June 30, 2013, that discussed the determination of the fair market value of solar projects for cash grant purposes. The memorandum is available here. In terms of the valuation methodology, the memo merely refers to the arm’s-length definition quoted above and the three valuation methods referred to above. The memo does contain some truisms like, “Discount rates should reflect an appropriate risk premium above the risk-free rate,” and the memo concludes with, “These and all other assumptions should be well-reasoned and sufficiently documented and should reflect market expectations.”

The pronouncements from the IRS and Treasury are silent with respect to a number of issues that are critical to the valuation of solar projects. For instance, how should the discounted cash flow model reflect the benefit of bonus depreciation and state tax benefits that few tax equity investors value and developers generally lack the tax appetite to use themselves. Then there’s the question of renewable energy certificates (RECs): the market for RECs in many states has fluctuated tremendously; tax equity investors generally do not value them; and most lenders will not lend against them. In running a discounted cash flow model, the question is unanswered in the IRS’s publications as to whether the model should include: today’s REC price for the life of the solar project; the average price of RECs over their relatively short history; or how a tax equity investor would value them.

SolarCity’s blog post references a white paper discussing the determination of fair market value of solar projects. The white paper was published by the Solar Energy Industry Association with assistance from CohnReznick; the white paper, in fact, references the uncertainty surrounding the valuation challenges referred to in the preceding paragraph and nowhere does it refer to the concept of methodology stipulated by the IRS. My blog post about the white paper is available here.

SolarCity is an important leader in the industry, and it serves itself and the industry well by correcting inaccuracies in press reports. Unfortunately, the complexities of tax law are frequently ill suited for sound bites. A company should be judged instead by its action.

1Barron’s, “Dark Clouds Over SolarCity,” Aug. 31, 2013, which is available here.

2Chadbourne & Parke, “The Distributed Solar Market”(Apr. 2013) (quoting Ben Cook, VP of Structured Finance, SolarCity “We use all three structures, but we see mostly partnership flips and inverted leases”), which is available here.

4See, e.g., Treas. Reg. §§1.485-5(d)(6)(i) (The fair market value of an investment is the price at which a willing buyer would purchase the investment from a willing seller in a bona fide, arm’s-length transaction.), 1.671-2(e)(ii). See also Rev. Rul. 59-60. 1959-1 C.B. 237 (discussing how to determine the fair market value of shares in a closely held corporation).